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Reportby the Comptroller
and Auditor General

Network Rail, Department for Transport, HM Treasury

Network Rail’s sale ofrailway arches

HC 2137SESSION 2017–2019

2 MAY 2019

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Network Rail, Department for Transport, HM Treasury

Network Rail’s sale ofrailway arches
Report by the Comptroller and Auditor General
Ordered by the House of Commons
to be printed on 1 May 2019
This report has been prepared under Section 6 of the
National Audit Act 1983 for presentation to the House ofCommons in accordance with Section 9 of the Act
Sir Amyas Morse KCB
Comptroller and Auditor General
National Audit Office
30 April 2019

HC 2137 | £10.00

This report examines the value for money of
Network Rail’s sale of railway arches.

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Contents
Key facts 4
Summary 5
Part One
Background and preparation for the sale 11
Part Two
Process of and proceeds from the sale 20
Part Three
Future considerations 30
Appendix One
Our audit approach 36
Appendix Two
Our evidence base 38
Appendix Three
Supporting information 39
The National Audit Office study teamconsisted of:Gregor Botlik, Andrew Carel-Maloney,
Imran Qureshi, Tommy Bourke andAron Dhinsa, under the direction ofSimon Reason.
This report can be found on the
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4 Key facts Network Rail’s sale of railway arches

Key facts£1.46bn

5,261

150 years

proceeds to Network
Rail from the sale of theproperty portfolio

rental spaces sold acrossEngland and Wales

length of the lease agreementwith the buyer as part of thesale and ongoing obligations
for Network RailMore than 50%

the percentage by which the sale price was higher than thegovernment’s retention value, which assumed no future
investment in the portfolio

35

number of indicative offers in the first phase of the sale, ahigh level relative to comparable government asset sales£500 million

the amount of sale proceeds HM Treasury agreed
could contribute to Network Rail’s funding shortfall forControl Period 5

Around £35 million

the amount spent on advisers and other transaction costs

40 months

the amount of time between the sale of the portfolio being
considered and the sale completing54%

the estimated rise in rents over the next three to four years
for a sample of properties owing to market conditions andirrespective of a sale

Network Rail’s sale of railway arches Summary 5

Summary

Introduction
1
In February 2019, Network Rail completed the £1.46 billion sale of a commercial
property portfolio to Telereal Trillium and Blackstone Property Partners. The portfolio
consists of 5,261 rental spaces across England and Wales that Network Rail judged
are not essential for running the railway. The portfolio is concentrated in the London
area (60% by number of rental spaces) and most properties are converted railway
arches (70% by number of rental spaces). The portfolio generated £83 million of rental
income in 2017-18, with the top 100 tenants making up 24% of expected revenues.
Around 100 staff have transferred with the portfolio, which was sold on a 150-yearleasehold basis.
2
Network Rail plans its activity in five-year periods, called Control Periods. The saleis part of Network Rail’s response to a funding shortfall in its investment programme
for Control Period 5 (2014 to 2019) identified in 2015. Network Rail was reclassified as apublic sector body in 2014. This prevented it from raising capital in the financial markets,as it had been able to in the past. The combination of cost increases and reclassification
meant that Network Rail and the Department for Transport (the Department) consideredthat Network Rail was no longer able to deliver its programme within the available
funding. This meant that the investment programme’s renewal (replacing worn-out
assets) and enhancement (improving the network) projects were underfunded and at
risk of being delayed or cancelled.
3
In November 2015, Sir Peter Hendy, Network Rail’s Chairman, published his
recommendations on how to replan Network Rail’s portfolio of work. Following this,Network Rail estimated that the cost of the work it intended to carry out by March 2019
exceeded available funding by £2.5 billion. Sir Peter Hendy’s report proposed an asset
disposal programme of around £1.8 billion and increasing the amount that it borrowed
from the Department by £700 million.

6 Summary Network Rail’s sale of railway arches

4This report looks at the main sale in Network Rail’s asset disposal programme,
the sale of a commercial property portfolio largely made up of railway arches. The sale
had four objectives, to:•not prejudice the safe and sustainable management of the railway infrastructure;•

reduce government’s main fiscal measures, public sector net borrowing (PSNB;‘the deficit’) and public sector net debt (PSND);•

maximise sale proceeds within the five-year Control Period 5(ending 31 March 2019); and•deliver value for money (compared with Network Rail retaining the portfolio).

5
Network Rail was responsible for preparing and executing the sale. The Department
gave final approval, as Network Rail’s shareholder. UK Government Investments(UKGI) advised the Department during the sale. HM Treasury was involved in setting
the sale objectives, including the budgetary impacts of the transaction, and agreed
the final decision to sell. And the Office of Rail and Road (ORR) took an interest in thetransaction as the regulator of Network Rail.

Study scope
6This report considers whether Network Rail achieved value for money in thedisposal of a major part of its commercial real estate portfolio, including:•the background and preparation for the sale (Part One);•the process of and proceeds from the sale (Part Two); and•the wider impacts of the sale (Part Three).

7
We have previously reported on the affordability and replanning of Network Rail’s
investment programme, including the decision to cancel three rail electrification projects.
This report does not consider these other elements of the replan. The report also does
not consider other sales in Network Rail’s asset disposal strategy or the achievement of
the strategy overall.

Network Rail’s sale of railway arches Summary 7

Key findings
Outcomes of the sale
8
Network Rail sold the portfolio for more than expected. Network Railvalued retaining the portfolio in public ownership at around £950 million, and valued
the portfolio from a buyer’s perspective at around £1.17 billion. Network Rail’s retain
valuation is conservative as it assumes that Network Rail would not be able to invest
in improving the portfolio because of the borrowing restrictions imposed by the
Department and HM Treasury, and it discounts future earnings more heavily thanthe market. Using a market discount rate and assuming no investment restrictions
the value of the portfolio is £1.4 billion.1 The sale price of £1.46 billion exceeded
Network Rail’s valuations. In exchange for the sale proceeds Network Rail forgoes
around £80 million of revenues per year. The sale means that Network Rail has
balanced its funding position for Control Period 5. However, this also follows thecancellation of projects (such as electrification works), efficiency targets imposed in
April 2017, and £1.8 billion of additional grant and loan funding from the Department.
Following an earlier agreement with HM Treasury, the sale contributes around£500 million to Network Rail’s funding shortfall for Control Period 5. The remaining
proceeds were used to offset against expected borrowing from the Department(paragraphs 2.13 to 2.20 and Figures 9 and 10).
9The leasehold sale structure supports Network Rail’s safe and sustainable
management objective at the expense of deficit reduction. HM Treasury stipulated
that, to count towards reducing the funding shortfall, the sale would need to reducethe deficit. This meant the structure of the sale would need to meet certain financial
accounting and reporting requirements; a freehold sale would have achieved this.
However, Network Rail identified that only a leasehold sale would ensure the railway
infrastructure could be managed safely and sustainably, as a lease would allow accessto the properties in the future, for example, for maintenance. The ORR was satisfied
that a leasehold sale could be structured in a way that would allow sufficient accessto its railway infrastructure to continue to manage its condition. Network Rail and theDepartment did not engage with HM Treasury to discuss the fiscal impact until late in
the preparation process. HM Treasury ultimately allowed some flexibility on the deficit
reduction objective. The final sale structure – a 150-year lease rather than a freehold
sale – gives Network Rail sufficient access to manage the railway infrastructure,but means that the sale did not fully meet the government’s fiscal objectives(paragraphs 1.11, 1.15 to 1.19, 2.20 and 3.7).

1‘Discounted cash flow’ is a way of estimating the value of an asset based on its future cash flows. Future cash flows
are estimated and discounted to give a present value: the higher the discount rate, the lower the value of those future
cash flows.

8 Summary Network Rail’s sale of railway arches

10 The Department and Network Rail did not explicitly seek to deliver wider
government policy objectives. Objectives, such as business support, tenant
protection or community cohesion, do not form part of Network Rail’s licenceconditions. Network Rail did not have such objectives before it was reclassified as apublic sector body either. However, Network Rail did consider government’s housing
policy as a part of its wider disposal plan, and excluded land with known residential
development potential from the sale so that this could be sold separately. The saleagreement did not include any provisions for protecting tenants, wider support forbusiness, or community regeneration plans, although Network Rail consideredthem qualitatively in its business cases. It concluded that future owners will haveeconomic incentives to invest in the portfolio, which means the portfolio will achievea higher level of external impact than it would in Network Rail’s ownership. The newowners also set out initiatives to support tenants, but these intentions are not legallybinding. Support to tenants was negotiated in the final stages of the sale process(paragraphs 1.12, 2.14, and 3.8 to 3.12 and Figure 18).
11 Network Rail expects the buyers to invest in the portfolio to increase
revenue. The portfolio offered investors the opportunity to become the largest landlord
to small- and medium-sized enterprises in the UK and benefit from a diverse tenantbase across England and Wales. Network Rail has forecast that the portfolio’s total
rental income will increase from £83 million in 2017-18 to £160 million in 2027-28, mainly
resulting from a £250 million investment programme (£36 million of the forecast growth)and expected rent increases (£39 million). There are also opportunities to commercialise
approximately 760 unrented spaces (around 15% of the portfolio). Network Rail’s
financial position did not allow it to exploit these opportunities before the sale. Following
the investment programme replan in 2015, much of the £162 million of funds earmarked
for investment in the portfolio was diverted to rail investment projects. Network Rail
expects the new owners to have an incentive to invest in the portfolio to increase theirreturns, which in turn would benefit existing tenants, future tenants and community
regeneration plans (paragraphs 1.13, 2.7, 2.14, 2.15, 2.18 and 3.8, Figure 3 and Figure 4).

Sale execution
12 The transaction was managed and executed professionally and generated
a large amount of market interest. Network Rail undertook an extensive process
to identify properties for sale. It excluded around 2,500 rental spaces because they
were either required for the operation of the railway or marked for future development.
The resulting portfolio was large for a single transaction, but indications of highinvestor demand supported the decision to pursue a single sale. A single transaction
also increased the likelihood of Network Rail achieving its objective to complete
a sale by March 2019. The sale generated substantial interest from investors andstrong competitive tension between bidders. More than 140 investors expressed aninterest, and Network Rail received 35 indicative bids in the first round. Network Railnarrowed the bidders down to 17 for the second round and five for the final round(paragraphs 1.14 to 1.16, 2.5 to 2.10, Figure 5 and Figure 8).

Network Rail’s sale of railway arches Summary 9

13 The sale took longer than expected and transaction costs exceeded
those estimated at the outset. The process completed two years later than theindicative timeline in the department’s asset disposal strategy (March 2016), and lessthan two months before the March 2019 deadline. Main contributors to the delay
included: the decision-making process between Network Rail, the Department andHM Treasury in relation to the sale structure and accounting treatment; and selectionof the properties for sale. Transaction costs were around £35 million, or 2.4% of
the overall proceeds. At sale launch, Network Rail expected costs to be around£20 million. The costs were affected by the choice of the leasehold sale structure,
which added complexity; the inclusion of an additional round in the sale process
in response to high bidder interest, which increased the cost of legal advisers; andthe cost of separating the property portfolio from Network Rail’s retained assets(paragraphs 2.19 to 2.21 and Figure 11).

Future considerations
14 Market conditions mean rents are likely to increase, irrespective of the sale.
Some tenants will change and the impact of the sale depends on the buyers’
future activities. The new owners have taken over the existing contracts with tenants.
As they implement their new business and investment strategy, the tenants may changeover time. The new owners have committed to adopting a ‘Tenants’ Charter’ to guidetheir practices in relation to tenants and their leases. The Department suggested acharter quite late in the process and it is not legally binding. The transaction’s wider
impact in terms of regenerating communities and creating jobs will depend on thelevel and timing of any buyer investment, but is not set out contractually. Network Railhighlighted to prospective buyers the upside potential of rents: it estimated a 54% rental
increase for a sample of properties over the next three to four years owing to market
conditions and irrespective of a sale (paragraphs 3.8 to 3.16 and Figure 13).
15 Network Rail continues to have an obligation to inspect and maintain therailway infrastructure. To ensure that the railway infrastructure is managed efficiently
and safely, Network Rail will have to manage its obligations over the 150-year leaseterm, such as managing the inspections of the rail infrastructure, landlords’ consent foralterations to the properties, and temporary or permanent repurchase of the properties(which could be at a premium to the sale price). Network Rail has established a
dedicated team that will manage the relationship with the new owners and ensure thatthey comply with the lease agreements. Network Rail estimates this team to cost around£1 million per year. Network Rail and its legal advisers believe that the legal framework inplace to ensure the safe operation of the railway has strengthened as a result of the sale(paragraphs 1.17, 3.2 to 3.7 and Figure 17).

10 Summary Network Rail’s sale of railway arches

Conclusion on value for money
16 Government’s policy is to sell assets where there is no policy reason for continued
public ownership. Network Rail sold this property portfolio in pursuit of that policy anddid so in a way that achieved the primary sale objective of not prejudicing the safe
and sustainable management of the railway infrastructure. Based on this outcome,and the fair price paid for the portfolio, the sale was value for money. It is, however,of some concern that the impact on tenants was not an explicit sale objective andwas only considered late in the sale process. The long-term value for money of thistransaction will depend upon several factors, including how Network Rail manages its
ongoing relationship with the leaseholder and the impact of the sale on stakeholders,
including tenants, and local economies.

Recommendations
17

We recommend:a

Before disposing of assets, HM Treasury and the selling department should
consider the potential impact of the disposal on wider government policy delivery.
Where the impact could be significant, the Department should engage with policy
leads in other departments to consider broadening the sale’s objectives.

b

The selling department should engage early with stakeholders that are likely to be(or perceive to be) affected by an asset sale – even in cases where this is unrelated
to the objectives of a sale – to reduce the risk of the transaction and allow theirviews to be considered by other parts of government.

c

The selling department should consider and document on a timely basis whether
contracting with the new owners in areas such as future investment plans andexplicit customer protections provides value for money.

d

Network Rail, and any department selling assets, should monitor whether future
owners comply fully with the commitments they made in their final bid to holdthem to account irrespective of whether these commitments form part of the
final sales contract.

Network Rail’s sale of railway arches Part One 11

Part One

Background and preparation for the sale
1.1 This part provides background information on Network Rail and the portfolio ofrental spaces it sold. This includes a description of the sale objectives and the properties
in the portfolio.

Background and wider context
1.2 Network Rail owns, operates and develops most of Britain’s rail infrastructure
and is responsible for its maintenance, renewal and enhancement. It plans investmentin the railway over a five-year ‘control period’, based on outputs that the Department
for Transport (the Department) specifies and the funding available to achieve them.
Network Rail’s plans for 2014 to 2019 (known as Control Period 5) were widely
acknowledged as ambitious: the then Prime Minister described it as “the biggest
modernisation of our railways since the Victorian era”.2
1.3 In September 2014, the Office for National Statistics (ONS) reclassified Network
Rail as a public sector body because of changes in European statistical rules. The
reclassification meant that Network Rail’s £34 billion debt now counted as government
debt.3 The Department and HM Treasury stopped Network Rail from raising new capitalin the financial markets as it had done previously, as this would increase government debt
at a time when the coalition government’s policy was to reduce it. Instead, during Control
Period 5, Network Rail could borrow from the Department under a loan facility cappedat £30.3 billion. This change in borrowing arrangements meant that Network Rail lost theflexibility to borrow to cover unexpected cost increases in its rail investment programme.
1.4 In June 2015, the then Secretary of State for Transport made public his
concerns about the affordability of the Control Period 5 rail investment programme.
The combination of cost increases and reclassification meant that Network Rail and theDepartment considered that Network Rail was no longer able to deliver its programmewithin the available funding. This meant that the investment programme’s renewal(replacing worn-out assets) and enhancement (improving the network) projects were
underfunded and at risk of being delayed or cancelled. We have previously reported on
the affordability of the programme.4 The Secretary of State announced a major replanof the enhancements programme by Network Rail’s new Chairman, Sir Peter Hendy.
2
3
4

Department for Transport, Investing in rail, investing in jobs and growth, press release, 16 July 2012, available at:www.gov.uk/government/news/investing-in-rail-investing-in-jobs-and-growth
Amount of current and non-current borrowing as of March 2014.
National Audit Office, Planning and delivery of the 2014–2019 rail investment programme, Memorandum to theCommittee of Public Accounts, September 2015, available at: www.nao.org.uk/report/pac-memorandum-planningand-delivery-of-the-2014-2019-rail-investment-programme/

12 Part One Network Rail’s sale of railway arches

1.5 In November 2015, Sir Peter Hendy published his recommendations on how to
replan Network Rail’s works portfolio.5 Network Rail estimated that the cost of the work
it intended to complete by March 2019 (the end of the control period) exceeded theavailable funding by £2.5 billion. Sir Peter Hendy’s report proposed addressing thisshortfall through an asset disposal programme of around £1.8 billion – selling non-coreand low-value assets – and increased borrowing from the Department of £700 million.
1.6 It is government policy to sell public assets where there is no policy reason to holdthem. We have previously reviewed similar sales due to this policy.6 In February 2016,
Network Rail proposed a detailed asset disposal strategy, which outlined how it
expected to generate £1.8 billion to support its investment programme. It considereda longlist of core and non-core assets that could be sold to generate proceeds during
Control Period 5. The property portfolio discussed in this report is Network Rail’s main
sale in its asset disposal strategy. Figure 1 provides a timetable of the events leading
up to the sale and the sale process itself.
1.7 Following further development of the asset disposal strategy, Network Rail realised
it was unlikely that the sales could be structured in a way to achieve its £1.8 billion target.
In April 2017, the Department agreed to lower Network Rail’s deficit-reducing receipts
target to £800 million. The resulting £1 billion shortfall was to be made up from delaying
or cancelling projects, efficiency savings and additional funding from the Department.
Figure 2 on page 14 provides a breakdown of Network Rail’s additional funding fromthe Department and asset sales over Control Period 5.

Sale objectives
1.8 Network Rail presented its strategic business case to the Department in March 2016.
This included high-level sale objectives and was endorsed by the Department’s Board
Investment and Commercial Committee and approved by ministers from the Department
and HM Treasury. Network Rail’s analysis indicated that the sale of the property portfolio
was the largest of the assets identified for disposal that were likely to meet the objectivesof the asset disposal strategy.
1.9 The sale of the property portfolio followed the objectives of the asset disposal
strategy and focused on the following four specific objectives to:•

not prejudice the safe and sustainable management of the railway infrastructure;•

reduce government’s main fiscal measures, public sector net borrowing(PSNB; ‘the deficit’)7 and public sector net debt (PSND);8•

maximise sale proceeds within Control Period 5 (ending 31 March 2019); and•deliver value for money (compared with Network Rail retaining the portfolio).

5
6
7
8

Sir Peter Hendy, Report from Sir Peter Hendy to the Secretary of State for Transport on the replanning of Network Rail’s
Investment Programme, Network Rail, November 2015.
The National Audit Office’s past work on asset sales and privatisations is available from our website: www.nao.org.uk/
search/pi_area/asset-sales-and-privatisation/type/report
Public sector net borrowing (PSNB) is a measure of government’s annual borrowing. It is the difference between
current expenditure and receipts. The measure excludes receipts from sales of non-financial assets.
Public sector net debt (PSND) is a measure of the amount the government owes less liquid assets such as cash.

Network Rail’s sale of railway arches Part One 13

Figure 1 Shows Timeline of events for selling the arches portfolio

Figure 1
Timeline of events for selling the arches portfolio
The sale of the arches portfolio began in 2017 and completed in February 2019
Key events leading up to the sale
April 2014

Control Period 5 begins, running until March 2019.1

September 2014

The Office for National Statistics reclassifies Network Rail as part of the
public sector.

November 2015

The Hendy Review is published, recommending an asset disposal
programme to raise £1.8 billion to help address a funding gap in
Network Rail’s investment programme.

March 2016

The Department for Transport (the Department) approves Network Rail’s Asset
Disposal Strategy, including the deficit reduction objective. It instructs Network
Rail to raise £1.8 billion deficit-reducing receipts from asset disposals.

April to December 2016

Network Rail begins a clearance process to establish which rental spaces toinclude in the sale. The Department, HM Treasury and Network Rail continue
to consider different sale structures to both ensure the safe operation of therailway and reduce the deficit.

January to
October 2017

Original expected completion date of the sale (May 2017) delayed toAugust 2018 due to ongoing discussions about the sale structure and thevolume of comments received during the clearance process. Preparation
for the sale.

April 2017

The Department revises Network Rail’s £1.8 billion deficit-reducing receipts
target to £800 million. HM Treasury agrees Network Rail can use up to£500 million of the proceeds, regardless of the ultimate accounting treatment.

October toNovember 2017

The Department, HM Treasury and ministerial approval obtained of theoutline business case for the sale.

Timeline of the sale process
November 2017

Sale launched, and expressions of interest accepted.

January to August 2018

Three-round competitive sale process.

September 2018

Sale announced at £1.46 billion to a consortium of two investors –Blackstone and Telereal Trillium.

February 2019

Sale completed.

March 2019

Control Period 5 ends.

Note
1 Network Rail plans its activity in five-year periods, called Control Periods.
Source: National Audit Office analysis of key events

14 Part One Network Rail’s sale of railway arches

Figure 2 shows Funding from the Department for Transport and asset sales

Figure 2
Funding from the Department for Transport and asset sales
Network Rail has balanced its funding position for Control Period 5 through assets sales, additional funding,cancellations and efficiencies1£ billion
34.00
33.00

0.97

1.44
0.11

32.00

0.58

31.00

1.21
32.67

30.00
30.30

29.00
28.00

Loan facility at
beginning ofControl Period 5

Additional grantfunding fromthe Department

Additional loan
funding fromthe Department

Proceeds
from otherasset sales

Proceeds
from thearches sale

Reduction inborrowing fromthe Department

Loan/funding positions
Increase
Decrease
Notes
1 Network Rail plans its activity in five-year periods, called Control Periods.
2This figure represents funding from the Department and asset sales only. It does not include other sources of funding,such as income from stations.

3‘Additional grant funding from the Department’ includes funding for Valley Lines Electrification and Gatwick, Thameslink,
additional enhancements, and other projects funding by the Department.

4‘Additional loan funding from the Department’ includes additional funding for electrification support and a reduction in loan
funding for Valley Lines Electrification and Gatwick.

5‘Proceeds from the arches sales’ are net of relevant transaction costs.

6

The final funding position reflects the fact that none of the arches portfolio sale proceeds are likely to meet the necessary financial
accounting and reporting requirements to count against the funding shortfall. However, following an earlier agreement withHM Treasury, Network Rail can still count £500 million of the proceeds against its funding shortfall for Control Period 5.

Source: National Audit Office analysis of Network Rail financial information

Total funding
from theDepartment
and asset sales

Network Rail’s sale of railway arches Part One 15

1.10 Ensuring the safe and sustainable management of the railway infrastructure wasa fundamental objective of the sale, and any sale option had to meet this objective.
Network Rail determined that any sale option must preserve its ability to access andcarry out works on the arches and surrounding property and prevent tenants fromdamaging or endangering the railway or its operations.
1.11 For proceeds to count towards reducing the funding shortfall, HM Treasury
stipulated that any sale would need to reduce the deficit. Furthermore, only funds
received in Control Period 5 could be used to fund the Control Period 5 investment
programme. Therefore, to count against the revised £800 million deficit-reducing
receipts target, proceeds would need to meet certain financial accounting andreporting requirements and be received before 31 March 2019.
1.12 Wider government policy objectives, such as business support, tenant protection
or community cohesion, were not objectives of the sale. They are not objectives of
either Network Rail or the Department, and do not form part of Network Rail’s licenceconditions agreed with the Office of Rail and Road (ORR). Network Rail told us thatit seeks to operate its property division on a commercial basis. It did not have any
wider policy objectives either before or after it was reclassified as a public sector body.
However, as a part of its broader asset disposal strategy, Network Rail considered
government’s housing policy objectives. Network Rail has a target to dispose ofland with capacity to build homes, which is part of the Department’s target set by
the Ministry of Housing, Communities & Local Government (MHCLG). Network Rail
therefore excluded land with known residential development potential from the sale.

The sale portfolio
1.13 The sale portfolio consisted of 5,261 rental spaces across England and Wales.
According to sale documentation, the portfolio’s owner is the largest landlord tosmall‑ and medium-sized enterprises in the UK (Figure 3 overleaf). Most of theproperties are converted railway arches and other land and buildings adjacent torailway tracks. The portfolio is diverse in property type, use, location and tenants(Figure 4 on page 17). It generated around £83 million in rental income in the2017‑18 financial year and required around 100 Network Rail staff to run.

Selection of the rental spaces included in the portfolio for sale
1.14 Network Rail undertook an extensive internal clearance process to establish
which rental spaces it would include in the portfolio for sale, starting with around
7,900 rental spaces within its commercial real estate division. Network Rail told
us it received 21,000 comments from internal stakeholders, which raised issues
relating to the sale of specific properties.9 Most of these queries related to railway
operational and maintenance matters or sites marked for future development.

9

The internal clearance process was undertaken with Network Rail’s nine Routes divisions; the teams who areresponsible for the day-to-day running of the railway.

16 Part One Network Rail’s sale of railway arches

Figure 3 shows Geographical spread of the portfolio of rental spaces soldFigure 3
Geographic spread of the rental spaces sold by Network RailThe portfolio is clustered around key urban centres, near major transport hubs in the
UK’s major cities
Number of rental spaces
101 or more
76 to 100
51 to 75
26 to 50
1 to 25
No rental spaces
in saleLondonNote
1 Scotland rental spaces were excluded from the sale.
Source: National Audit Office analysis of the portfolio of rental spaces sold

Network Rail’s sale of railway arches Part One 17

Figure 3 shows Analysis of the rental spaces sold by Network Rail

Figure 4
Analysis of the rental spaces sold by Network RailThe portfolio has a diverse use and tenant base and is situated mainly in London
Location

Usage
Offices, car parking,vehicles and machinery, 7%

North, 20%

Industrial, 26%

Storage, 14%South West
and Midlands,
20%

London, 60%
Leisure, 14%

Other, 22%
Retail, 17%

Rental space
Land, 11%

Rental income by tenant

Other, 1%

Top 10, 6%
Next 10, 4%
Next 30, 7%
Next 50, 7%

Building, 18%
Arch, 70%

Notes
1 Chart based on number of rental spaces.
2

Totals may not sum due to rounding.

Source: National Audit Office analysis of the portfolio of rental spaces sold

Next 100, 10%

Remaining,67%

18 Part One Network Rail’s sale of railway arches

1.15 Alongside the clearance process Network Rail’s legal advisers developed thelease agreement with the aim of ensuring the rights and protections were sufficientfor Network Rail to continue to operate and maintain the railway. A Network Railinternal panel comprising representatives from across the organisation agreed ona site‑by‑site basis whether the risks identified could be mitigated through a sale.
Where this was unlikely, sites were excluded from the sale. In addition, Network Railretained sites marked for immediate or near future rail projects with committed
funding, and sites with potential for residential development. In all, 1,158 were
excluded due to safety concerns or development needs. Network Rail also agreed
with Transport Scotland to exclude 578 rental spaces located in Scotland.
1.16 Figure 5 below shows how Network Rail selected the rental spaces includedin the sale.

Figure 5 shows Overview of how Network Rail selected the rental spaces included in the portfolio for sale

Figure 5
Overview of how Network Rail selected the rental spaces included in the portfolio for sale
Network Rail’s clearance process identified 5,261 rental spaces for sale out of 7,885
Number of rental spaces
9,000
8,000
431
578

7,000

469
457

6,000

689
5,000
4,000

7,885

3,000
5,261
2,000
1,000
0

All rental spaces
per Network Raillisting

Perimeter position

Notional
accounting
records

Rental spaces
in Scotland

Spaces marked
for residential
and commercial
development

Other (including
property andlegal review)

RemovedNotes
1 Notional accounting records – historical records of previously owned assets or duplicate entries.
2

The removal of Scotland from the portfolio, as agreed with Transport Scotland.

3

Other – rental spaces that it is not practical for a third party to maintain due to Network Rail’s access needs.

Source: National Audit Office analysis of business case information

Excluded forrail-related
reasons followinginternal clearance
process

Final sale
perimeter

Network Rail’s sale of railway arches Part One 19

Selection of sale structure
1.17 The portfolio was sold under a 150-year long lease and the sale included thetransfer of staff and related management infrastructure to the new owner. Network Raildecided that it needed to sell the portfolio on a leasehold rather than freehold basis
because it needed to maintain sufficient access rights to ensure the continued
operations and safety of the railway. Retaining the freehold means that Network Railretains a degree of control over how the rental spaces are used and managed.
1.18 Network Rail’s early analysis was that a leasehold sale could not be structured
in a way that any of the sale proceeds would reduce the deficit. Only a freehold salewould transfer sufficient control of the portfolio to a new owner, and thus result in saleproceeds reducing the deficit. Throughout 2016 and early 2017, Network Rail and theDepartment continued to develop sale options that would maximise the impact of thesale on the deficit. Network Rail and the Department did not engage with HM Treasuryclassification experts until late 2016, almost 18 months after the deficit reduction
objective was set. Network Rail and the Department considered selling the freeholdof the portfolio, with legislation to ensure it maintained access rights, but legal advice
obtained in May 2016 judged that this would be ineffective.
1.19 The Department and HM Treasury expected some of the sale proceeds to
be classified as a deficit-reducing receipt, despite the leasehold nature of the sale.
However, the ONS only provides a formal opinion on statistical treatment after a saleis completed. To address this uncertainty and ensure Network Rail could use theproceeds to fund its investment programme, HM Treasury agreed in April 2017 to takeon the ‘accounting risk’ of the transaction. This meant that, even if the sale proceeds
were ultimately not classified as deficit-reducing by the ONS, Network Rail would still
be able to use up to £500 million of the proceeds to contribute to its funding shortfall
in Control Period 5.

20 Part Two Network Rail’s sale of railway arches

Part Two

Process of and proceeds from the sale
2.1 This part examines: the governance arrangements for the sale; the sale options
that Network Rail and the Department for Transport (the Department) considered; salepreparation and execution; sale proceeds and how they affect public sector finances;and the transaction costs.

Governance arrangements
2.2 Network Rail was the main party responsible for preparing and executing thesale, which was led by two internal working groups. The Commercial Group monitored,
evaluated and controlled the progress of the transaction, and the priorities, risks anddecisions involved in the sale. The Change and Separation Group monitored theprogress of work required to dispose of the portfolio and ensured that appropriate
approval for decisions had been sought within Network Rail.
2.3 The Department – as Network Rail’s shareholder – provided approval at key
stages of the transaction. It approved the sale’s rationale and objectives, its launch,and the selection of bidders. HM Treasury was involved in setting the sale’s objectives
and the accounting treatment, and also approved the launch and the decision to sell.
In September 2018, ministers from the Department and HM Treasury gave final approval
for the sale to go ahead, following approval by the Network Rail Board and other related
project committees. Figure 6 provides an overview of the governance arrangements.
Appendix Three provides an overview of the roles of the main parties involved in the sale.

Sale options
2.4 In the September 2017 outline business case, Network Rail considered a wide
range of options to achieve a sale that met government’s objectives. All sale options
assumed that Network Rail sold the leasehold rights and not freehold rights of theportfolio. These options included sale of the rental spaces as a single portfolio,
multiple sales or sales on an individual basis, and other disposal options, such as
forming a joint venture with a third party or selling the portfolio in the form of an
initial public offering (IPO) of shares on a stock exchange (Figure 7 on page 22).

Network Rail’s sale of railway arches Part Two 21

Figure 6 shows Governance structure for the arches sale

Figure 6
Governance structure for the arches sale
Network Rail ran the sale with final approval from Department for Transport and HM Treasury
HM Treasury

Approval
Department forTransport

UK Government
Investments

Approval

Regulatory consent
Office of Railand Road

AdviceNetwork RailKey project boards
Commercial
Group

Business Change
and Separation

Source: National Audit Office analysis of business cases and other governance documents

2.5 Network Rail, the Department and UK Government Investments (UKGI) spentaround nine months considering whether they could maximise value for money by
selling the portfolio whole or piecemeal. Network Rail told us that continuity of staff at
the Department and UKGI could have improved the process but acknowledged thatthey supported them fully in critical stages of the transaction. Network Rail’s financial
and property advisers suggested that, given the likely strong interest in the portfolio,
the portfolio sale would gain a ‘portfolio premium’ as the premium value of the London
properties would increase the value attributed to the non-London properties (relative toa series of smaller transactions). In addition, the advisers stated the large scale of theportfolio would be attractive to established global investors who were trying to build
large UK property portfolios and had surplus capital. Network Rail and its advisers saw
value in the uniqueness of the portfolio, and considered that dividing the portfolio would
remove this. They also concluded that the cost to sell would be significantly higher for
multiple transactions.
2.6 Network Rail concluded that a single sale presented the most attractive option,owing to the balance of: costs and complexity of managing the relationship with thenew owners; the profile of risk and benefits; transaction costs; and completion before
March 2019.

22 Part Two Network Rail’s sale of railway arches

Figure 7 Shows Disposal options from the outline business case

Figure 7
Disposal options from the outline business case
The portfolio sale had the best expected outcome of reaching all objectives
Disposal options

Sale objectives
Portfolio
sale1

Break-up2

Piecemeal
sale 3Joint
arrangement4

IPO 5

Securing the safety andoperations of the railway

Saleproceeds
from fiscal
measuresDebt
reduction
Deficitreduction

Sale proceeds received
by March 2019
Value for money

Meets all of objective
Does not meet objective
Notes
1 Portfolio sale – a large proportion of the portfolio to be sold as a single entity to a private buyer.
2

Break-up – the portfolio to be broken into several distinct businesses before being sold off to buyers.

3

Piecemeal sale – the portfolio to be sold on a rental space basis.

4

Joint arrangement – an arrangement by which two or more parties had joint control, one of which would havecontinued to be Network Rail.

5

IPO (Initial public offering) – the very first sale of stock issued by a company to the public.

Source: National Audit Office analysis of business case information

Sale process
2.7 Network Rail launched the sale in November 2017. The sale process was athree‑round competitive auction, intended to create competitive tension among bidders(Figure 8). Network Rail presented the portfolio to investors as a “significant asset
management opportunity”. It forecast that the total rental income of the portfolio
would increase from £83 million in 2017-18 to £160 million in 2027-28, mainly becauseof a £250 million investment programme (£36 million of the forecast growth) and
expected rental increases (£39 million of the forecast growth). It received 143 formal
expressions of interest, which the financial advisers conducting the process
regarded as ‘unprecedented’, considering the type and size of transaction.

Network Rail’s sale of railway arches Part Two 23

Figure 8 Shows The sale process for Network Rail’s sale of railway arches

Figure 8
The sale process for Network Rail’s sale of railway arches
The sale attracted substantial investor interest and competitive tension
Stage

Expressions of interest

Round 1Round 1B

Round 2

PurposeTo advertise thesale and encourage
wide involvement in
the process.

To provide bidders with
sufficient information todetermine which bidders
would go through to thenext round.

To determine which bidders
should be taken through todetailed due diligence.

To provide bidders
with information before
receiving final offers.

TimingNovember toDecember 2017

January to March 2018

March to May 2018

June to August 2018

Information
provided
to bidders

A short teaser, settingout summary informationon the opportunity.

An information
memorandum containing
detailed information on
the portfolio.

Vendor due
diligence reports.

Further due diligencereports and meetings withkey advisers.

A summary of the key
terms of the head lease.
A financial modelof the portfolio basedon Network Rail’s
business plan.

Information on specificinvestment opportunities
and costs.
Drafts of transaction
documents and warranties
and indemnities.
Meetings with management
and answers to queries.

Full access to data roomwith around 33,000
documents covering all
aspects of the portfolio.
Meetings withmanagement, site
inspections and answers
to queries.

Bidder response

More than 140 parties
formally registered
their interest.

35 indicative offers.

Ten indicative offers.

Four firm offers.

Bid range(average)n/a£905 million to£1,350 million£1,315 million to£1,575 million£1,325 million to£1,461 million(median: £1,150 million)(median: £1,400 million)(median: £1,404 million)

17 bidders were taken into
the next round, based on
price, deliverability andrailway safety.

Five bidders were taken into
the next round.

Two bidders were invited
to submit their best andfinal offers. A consortium– Blackstone and Telereal
Trillium – raised its bid
by around 2.5% andwas selected.

ResultAll parties that registeredformal interest wereadmitted to the firstformal phase of
the process.

Source: National Audit Office analysis of business cases and advisers’ reports

24 Part Two Network Rail’s sale of railway arches

2.8 During Round 1, it received 35 indicative offers from a range of bidders, including
institutional investors, private equity funds and property investment companies. Owing
to the scale of interest during this round, Network Rail introduced an additional roundof bidding before allowing bidders to undertake detailed due diligence. Network Railalso engaged an additional legal adviser, in part to increase capacity in response to
the level of interest.
2.9 Ten of the 17 bidders taken into Round 1B submitted revised bids. Network Railassessed these bids against price, deliverability and railway safety. Five bidders weretaken to Round 2 and began 10 weeks of detailed due diligence. Bidders were given
access to around 33,000 documents covering all aspects of the portfolio and offeredfurther meetings with management and advisers, site inspections and answers toqueries. Four firm offers were received, and the two leading bidders were invited tosubmit their final and best offers.
2.10 Network Rail selected a consortium of two investors – Blackstone and Telereal
Trillium – that formed a joint venture called ‘The Arch Company’. The sale formallycompleted on 4 February 2019 for £1.46 billion.

Sale proceeds
2.11 This section considers the financial outcomes of the sale. Part Three looks at
the wider impact of the sale on the safe operation of the railway, and the impact oncommunities and existing tenants.

Sale price compared to valuations
2.12 Network Rail performed multiple valuations which can be classified into
two categories:•

Retain valuation: This valuation represents the value of retaining the portfolio in
public ownership and takes account of Network Rail’s limited ability to invest in
the portfolio. Government used this valuation to determine whether to sell or retain
the portfolio.

•

Sale valuation: This valuation represents the price Network Rail expects potential
buyers to offer and takes full account of the investment opportunities identified
by Network Rail’s management. It is used to determine whether the price offered
by a potential buyer is fair for the portfolio being sold.

2.13 Network Rail sold the portfolio for cash proceeds of £1.46 billion. This was morethan 50% higher than Network Rail’s retain valuation (around £950 million) and 27%
higher than its pre-launch sale valuation (around £1.17 billion) (Figure 9).

Network Rail’s sale of railway arches Part Two 25

Figure 9 shows a Comparison of the sale price to Network Rail’s pre-launch valuations

Figure 9Comparison of the sale price to Network Rail’s pre-launch valuations
The final sale price was 54% higher than Network Rail’s retain valuation, which was influenced by its limitation
to invest and the use of a higher discount rate
£ million
1,600
1,400
290
1,200
77
144

1,000
800

1,460
600

1,170
949

400
200
0

Retain valuation(Sep 2017)

Gains from future
investments

Gains fromexpected growth3

Sale valuation(Sep 2017)

Differential to
final sale price

Network Rail’s pre-launch valuations
Increases
Final sale priceNotes
1 Retain valuation – this valuation represents the value of retaining the portfolio in public ownership and takes account of
Network Rail’s limited ability to invest in it. It is used to determine whether it is more valuable to sell or retain the portfolio.
It assumed limited investment in the portfolio, based on Network Rail’s actual investment plans for the property portfolio.
As Network Rail is constrained in its ability to invest in development opportunities, it cannot take advantage of the increase
in rent due to improving the assets.
2

Sale valuation – this valuation represents the price Network Rail expected potential buyers to offer and takes full account of
the investment opportunities identified by Network Rail’s management. It is used to determine whether the price offered bya potential buyer is fair for the portfolio being sold. It assumes that the owner does not have any investment constraints andtakes account of all development opportunities identified.

3

Expected gains from market rent growth – the retain case assumes that after three years, rents will fall by 1% per year as theportfolio deteriorates due to limited capital expenditure.

4

This figure excludes transaction costs.

Source: National Audit Office analysis of business cases and advisers’ reports

Final sale price(Feb 2019)26 Part Two Network Rail’s sale of railway arches

2.14 Network Rail’s retain case valuation assumed that it would not be able to invest
money in developing the portfolio in future years. Before the sale, Network Rail produced
a development plan for improving the portfolio, which required around £250 millionof investment over the next eight years. This development plan would affect morethan 500 rental spaces and is expected to offer an average return of around 10%.
Network Rail is limited in its ability to invest in the portfolio, and it told us it would havebeen difficult to justify investing in the portfolio at the expense of core railway-related
projects.10 Network Rail expected the offers of potential buyers to reflect the full valueof this development potential and in its sale valuation it assumed the buyer would nothave investment constraints. Network Rail’s sale valuation reflects the potential of theportfolio and makes it more comparable with how a potential investor would value
the portfolio. Network Rail conducted these valuations at the outline business caseapproval stage to assess whether or not to go ahead with a sale.
2.15 Network Rail’s valuations use the Social Time Preference Rate (STPR) to discountcash flows, in line with HM Treasury’s Green Book guidance. This rate is often higher
than the rate a buyer would use to value an asset in an acquisition. The higher discountrate reduces the present value of the future cash flows, and explains some of the£290 million differential between the sale valuation and final sale price. Therefore,
while Network Rail’s use of the STPR is compliant with government’s methodology,
this makes the valuation conservative. We have previously commented on the useof this rate in other government asset sale valuations.11
2.16 Network Rail’s financial adviser also valued the portfolio by applying a discountrate based on comparable companies and assuming no investment restrictions; using
a discount rate of 6.75% implied a sale valuation of £1.4 billion, which was significantly
closer to the final price achieved in the sale. This comparison assumes only changes inthe discount rate. The other main factor affecting the present value of future cash flows
is the expectation of future rental income; the new owners made their own forecasts
and did not use the management forecasts. Figure 10 illustrates the values of theportfolio based on different valuation cases and discount rates.
2.17 There is inherent uncertainty in the value of commercial rents over the long term
and therefore the value of the portfolio. In our recent report The Ministry of Defence’s
arrangement with Annington Property Limited, we found that the Ministry of Defence lostout on billions of pounds worth of increases in asset values due to price increases thescale of which could not have been foreseen at the time of the deal.12 In Network Rail’scase, the future rents will affect the price it would need to pay the new owners in orderto temporarily or permanently take back the assets. If rents increase by more (less) than
expected a take-back could cost more (less) than the proceeds it received from the sale.

10 Network Rail’s original business plan for Control Period 5 included £162 million for investment in the portfolio. This was
subsequently reduced to £82 million by late 2015, substantially below the level of investment potential of the portfolio.
Network Rail conducted multiple retain case scenarios to reflect potential changes to its ability to invest in the future.
11 The National Audit Office’s past work on asset sales and privatisations is available from our website: www.nao.org.uk/
search/pi_area/asset-sales-and-privatisation/type/report
12 Comptroller and Auditor General, The Ministry of Defence’s arrangement with Annington Property Limited, Session
2017–2019, HC 762, National Audit Office, January 2018. Available at: www.nao.org.uk/report/the-ministry-ofdefences-arrangement-with-annington-property-limited/Network Rail’s sale of railway arches Part Two 27

Figure 10 shows a Summary of Network Rail’s valuations

Figure 10
Summary of Network Rail’s valuations
The higher valuations assume that all investment projects are funded and use a market rate todiscount cash flows
Type of valuation

Cash flow assumptions

Discount rate
assumptions

Valuation

Retain valuation(September 2017)

No funding available to invest
in the portfolio.

Based on Social Time
Preference Rate 2(8.6%)£949 million

Based on Social Time
Preference Rate 2(8.6%)£1.17 billion

Rent growth falls after Year 3
due to underinvestment.
Only 80% of the potential
rent uplift to market prices
is achieved.
Unlettable rental spaces
remain vacant.
Sale valuation(September 2017)

All investment projects
are funded.
Only 80% of the potential
rent uplift to market prices
is achieved.
Unlettable rental spaces
remain vacant.

Sale valuation using amarket discount rate 3(August 2018)

The same as thesale valuation.

Based on broker
research of comparable
listed peers(6.75%)£1.4 billion

Full businesscase valuations(August 2018)

The same as the salevaluation with various
investment and growthscenarios modelled.

Ranges between
6.5% to 8.75%£1.1 billion to£1.4 billion

Final sale price(Agreed in
September 2018)––£1.46 billion

Notes
1 Network Rail’s main valuations are based on a discounted cash flow approach. The cash flows of the portfolio(for example, rental income, management costs) are forecast over a 10-year period, from 2018 to 2028, and then aterminal value was used. These cash flows are then ‘discounted’ to estimate what these future cash flows are worth
today. The ‘discount rate’ used to do this is based on benchmarking and professional judgement.
2

HM Treasury’s Green Book guidance recommends discounting future cash flows using the Social Time Preference
Rate that reflects the value to society of cash today rather than in the future.

3

The market comparison uses a discount rate based on comparable companies. It does not apply a premium for the
specific risk of the portfolio.

Source: National Audit Office analysis of valuation information

28 Part Two Network Rail’s sale of railway arches

2.18 The portfolio also contains 762 properties that are not currently rented out andcould potentially be commercialised by future owners. These make up about 15% of
the overall portfolio. Network Rail told us that some of these properties are not currently
lettable, but it expects that many of the issues can be resolved through negotiation,for example to gain rights of access, or investment. Network Rail did not fully quantify
the additional returns the new owners might expect for bringing these properties into
use. We expect that the value of this development potential is also reflected in the
difference between Network Rail’s sale valuation and the final sale price.

Timing and impact on the public finances
2.19 The sale process was completed during Control Period 5, which was a sale
success criteria. However, it completed two years later than the indicative timeline in
the Department’s asset disposal programme strategy (March 2016), and less than
two months before the 31 March 2019 deadline. In all the process took 40 months,
between the sale of the portfolio being considered in the Hendy Review and the salecompleting. Main contributors to the delay included the decision-making process
between Network Rail, the Department and HM Treasury in relation to the salestructure (paragraph 1.18), accounting treatment (paragraph 1.19), and selectionof the properties for sale (paragraph 1.14 and 1.16).
2.20 While Network Rail and the Department initially expected some proceeds to reduce
public sector net borrowing (PSNB; ‘the deficit’), the sale is unlikely to meet the required
financial accounting and reporting requirements. The sale agreement includes a transferof staff, and Network Rail and the Department only realised the impact of this transfer
on the accounting treatment in March 2017. This feature means the sale proceeds will
likely not reduce the deficit. The sale means that Network Rail has balanced its funding
position for Control Period 5. However, this also follows the cancellation of projects(such as electrification works), efficiency targets imposed in April 2017 and £1.8 billion of
additional grant and loan funding from the Department. Following an earlier agreementwith HM Treasury, Network Rail is able to use £500 million of the proceeds to contributeto its funding shortfall for Control Period 5. This will increase the deficit by £500 million.
The remaining proceeds were used to offset against expected borrowing from the
Department, by reducing the loan facility available to Network Rail. The sale reduced
public sector net debt (PSND) by £960 million.

Network Rail’s sale of railway arches Part Two 29

Advisers and other transaction costs
2.21 The total cost of the transaction was around £35 million, or around 2.4% ofproceeds (Figure 11). When the sale was launched costs were expected to be£20 million. The costs in this case were affected by the choice of the leasehold salestructure, which added complexity (see paragraph 1.17); the inclusion of an additionalround in the sale process in response to high bidder interest, which increased
the cost of legal advisers; and the costs of separating the property portfolio from
Figure11 Shows
Transaction
and adviser
costs for Network Rail’s sale of railway arches
NetworkRail’sretained
assets.

Figure 11
Transaction and adviser costs for Network Rail’s sale of railway arches
Business separation and legal cost made up more than half of the external cost of the transaction
Costs

Description

Total
(£)

Internal team

Network Rail team running the sale

6,800,000¹

Financial advisers

Rothschild & Co, EY

9,463,229

Legal advisers

Clifford Chance, Eversheds

8,838,326

Business separation

BAE Systems and other suppliers

7,881,786

Other transaction costs

Other due diligence, property andtransaction support

1,858,177

External

Total external costs

28,041,518

Total costs

34,841,518

Notes
1 This includes costs up to full business case stage (August 2018).
2

Of total external costs, around £11.7 million relates to the preparation of the transaction (including the cost of
preparing the business for sale and separating it from Network Rail) and around £16.3 million relates to the saleprocess and the execution of the transaction.

Source: National Audit Office analysis of full business case and further cost updates

30 Part Three Network Rail’s sale of railway arches

Part Three

Future considerations
3.1 This part looks at the wider impact of the sale on the safe operation of the railway,
and the impact on communities and existing tenants.

Ensuring the safe operation of the railway
3.2 Network Rail must ensure the operations and safety of the railway, irrespective ofwhether the portfolio was sold. As much of the portfolio is either physically connectedor adjacent to the railway, there will be an ongoing relationship between Network Railand the future owners over the whole length of the 150-year lease. There are four key
transaction documents in relation to the sale. The most important in relation to theprotective provision of the railway is the head lease (see Appendix Three, Figure 16).
3.3 The head lease contains the railway protective provisions and sets out Network
Rail’s and the new owner’s obligations (see Appendix Three, Figures 18 and 19).
It also includes provision to allow Network Rail to inspect the arches, to carry out
works required for the repair and renewal of the railway infrastructure, and to prevent
occupational tenants from damaging or endangering the railway or its operations.
Network Rail performed these activities before the sale. After the sale, it will engage
in new activities, such as monitoring whether the future owners comply withthese lease terms.
3.4 Network Rail has set up an interface team to manage its obligations after the saleand interact with future owners (see Appendix Three, Figure 17). Network Rail identified
this post-sale relationship as low risk, following mitigation, on its risk register. It didnote that an adequately resourced interface team, with clear roles and responsibilities,
is essential to ensure that the future relationship between Network Rail and the newowners is successful. Network Rail expects the cost of the team to be around £1 million
per year and the terms of the head lease provides incentive for the interface teamto act efficiently.
3.5 The head lease allows the new owner to sell on parts of the portfolio. This is limited
to 10 parts, which must each contain at least 500 rental spaces. The size constraints
ensure that any future owners have the substance and financial standing to protect
Network Rail’s ability to enforce the railway-protective provisions. This also limits the
future burden on Network Rail’s interface team by limiting the number of parties it
needs to interact with.

Network Rail’s sale of railway arches Part Three 31

3.6 The head lease also gives Network Rail the ability to take back rental spaces as
required to deliver railway-related projects. Should Network Rail temporarily or permanently
take back rental spaces for railway purposes, it will need to pay compensation either inthe form of missed rent for the period required or by buying back the properties at market
value. Network Rail has not estimated how much this is likely to cost over the length of thelease. If the new owners improve the portfolio and rents go up, this will increase the costof taking back rental spaces in the future, the opposite is also true.
3.7 In July 2017, before launching the sale, Network Rail met with the Office of Rail andRoad (ORR) to present the rights and protections within the key transaction documents.
Network Rail and its legal advisers believe that the legal framework in place to ensure thesafe operation of the railway has strengthened as a result of the sale. The key transaction
documents simplify and standardise Network Rail’s framework compared with theindividual leases it had in place before a sale. ORR was content that the key proposed
lease terms were consistent with Network Rail’s existing approach to letting properties.
On that basis, ORR agreed that the proposed sale terms were consistent with the generalconsent for land disposals under Network Rail’s licensing conditions (except for a small
number of properties that required specific consent).

Impact on communities and existing tenants
3.8 The portfolio represents the largest provider of space to small- and medium-sizedenterprises (SMEs) in the UK, with a diverse tenant base spread across England andWales (paragraph 1.13). Network Rail recognised the importance that the portfolio has
on businesses, communities and the continued economic growth of Britain. But it was
not able to quantify this importance, so in its sale business case it sought to assess thenon‑monetary impacts of the portfolio in relation to regenerating the community andcreating jobs. It concluded that, owing to Network Rail’s inability to invest fully in theportfolio, private ownership should provide greater benefits in these areas. Network Railjudged that the new owners would have sufficient incentive to invest to maximise theirreturns, and was concerned that asking for specific commitments may impact the sale price(paragraph 2.14). As a result, Network Rail did not ask for binding investment commitments.
3.9 In July 2018, the Guardians of the Arches, an association of tenants that represented
about 6.5% of the overall tenants at the beginning of 2019, met with the then rail minister.
Following the meeting, they formally raised their concerns in a letter. Their demands included
formal recognition as a tenants’ association, ability to purchase discrete parts of the portfolio,
more favourable rental terms and security of tenure. Network Rail objected to most of theissues raised on the basis that acting on them would conflict with HM Treasury’s Managing
Public Money principles.13 However, Network Rail obtained non‑binding commitments fromthe new owner, including that it will adhere to good practice and standards in a tenants’charter. These commitments were given late in the process and at the Department forTransport’s (the Department’s) request. Network Rail felt that stronger tenant protections
were unnecessary as the sale agreement ensures that existing leases remain in place, andthat stronger protections would contravene its requirement to act commercially and could
raise the risk of a judicial review or State Aid challenge. We understand from the newowners that they intend to publish a charter before summer 2019.
13 HM Treasury, Managing Public Money, June 2013. Available at: https://assets.publishing.service.gov.uk/government/
uploads/system/uploads/attachment_data/file/742188/Managing_Public_Money__MPM__2018.pdf

32 Part Three Network Rail’s sale of railway arches

3.10 The new owner sees significant alignment between its interests, Network Rail’s
interests and objectives and those of SMEs and local communities. The new ownerbelieves that the sale will have an “overwhelmingly positive” impact on current andfuture occupational tenants within the portfolio and has committed to initiatives tosupport tenants, including:•a Tenants’ Charter, which would set out the principles of tenant relations;•a tenant engagement team to interact with tenants on a highly responsive andtransparent basis;•a protocol to provide financial and other support for long-tenured SME tenants
that are facing, or may face, acute financial pressure; and•an “environment where SMEs can prosper”, through bringing several hundred
spaces deemed as ‘unlettable’ by Network Rail into use and, following
considerable capital investment, create more and better space for SMEs.

3.11 The actual wider economic impact will depend on the business and investment
strategy of future owners. The new owner is currently developing its business strategy,
and expressed the following guiding principles:aAsset management – focus on rent review where the properties do not require
further material investment. Such reviews would take account of affordability andapply a (yet to be developed) protocol to provide financial and other support forlong‑tenured small business tenants that are facing, or may face, acute
financial pressure.

b

Letting the vacant units – a significant focus on ensuring that units that are
currently vacant are converted to a lettable standard swiftly.

c

Minor enhancement – undertake site inspections to identify properties
for refurbishments.

dEnhancement projects – undertake a full viability study on larger investment
projects before investing meaningful capital in the portfolio.

3.12 The new owner has taken on Network Rail’s existing lease agreements andtenants’ contractual obligations are therefore unchanged. Figure 12 provides an
overview of the type of contracts currently in place. As the new owner implements
its business and investment strategy, the mix of tenants (see Figure 4) and contracts
in place may change over time. In September 2018, the buyer committed towriting to tenants once a year setting out the number of arches which have hada change of use as well as the number of units that have been refurbishedin each case during the previous 12-month period.

Network Rail’s sale of railway arches Part Three 33

Figure 12 Shows a Summary of lease terms of the property portfolio by typeFigure 12
Summary of lease terms of the property portfolio by type
The portfolio is made up of a range of leases that in general have a three- to six-yearly rent review and three- to six-month
break clauses
Lease type
Fixed-term lease

Number£ million 2

748

29.7

Description

Tenantbreak

Landlord
break

Rent
review

A lease over a fixed amount of time (term)
where tenant benefits from rights andprotections under the Landlord & Tenants
Act 1954 (L&T Act). If the landlord opposes
renewal at the end of the term, they must
demonstrate the statutory grounds outlined
in section 30 of the L&T Act.

Subject tonegotiation

Subject tonegotiation

3 or 6months6 months

Rolling
6-monthRolling
6-month

Rolling
3-monthRolling
6-monthThis type of agreement is used where bothlandlord and tenant want additional security
and longevity to invest (tenant may also haveright to assign).
Typically rent reviews occur every five years.
Fixed-term(contracted out)

681

21.7

A fixed-term lease (as above), althoughexplicitly ‘contracted out’ of the L&T Act.
Used where ability of Network Rail to obtainpossession quickly, cheaply and without
challenge is important (for example, where amajor enhancement may be planned).
Typically rent reviews occur every three years.

Rolling-term lease

818

17.8

A rolling tenancy which continues indefinitely
until either landlord or tenant serves notice tobreak the agreement (usually with six months’
notice period). For the landlord to breakthese agreements requires demonstrationof statutory grounds outlined in section 30of the L&T Act.
Typically rent reviews occur every three years.

Rolling-term leasewith indexation

1,498

16.7

As above but with annual index linked
rental uplifts.
Typically rent reviews occur every six years.

Total

3,745

85.9

Notes
1 Total number of leases (rental agreements) in place at time of completion was 3,745 of a total of 5,261 rental spaces. The remainder is made up of
762 spaces which are not able to be let, 445 spaces which are available to be let, 135 ‘Other’, 93 under development and 81 leased by Network Rail.
2

The financial information presented here shows the expected rental income under the lease agreements in place at sale completion. This may differ from
actual rental income owing to a number of reasons, for example, rental spaces being vacant for parts of the year or, and rent increases during the year.
The portfolio generated £83 million of rental income in 2017-18.

Source: National Audit Office analysis of the portfolio of rental spaces sold

34 Part Three Network Rail’s sale of railway arches

3.13 Most of the lease contracts include a rent review event every three to six years,
and some contracts include annual increases in line with the retail prices index.
Figure 13 illustrates the profile of future rent reviews of the portfolio. At a rent review
event, the owner and tenants renegotiate the rent. Rents are set in line with comparable
properties in the local area and tenants have the right to arbitration if they disagree withthe proposed rental level. Actual rents may differ from market rents owing to the time
between when rents are set and when they are reviewed.
3.14 Between 2014 and 2017, rent increases at review events averaged 26% for existing
tenants and 39% for new tenants. There were strong variations over time, with averages
ranging between 9% and 77%. Rental increases on individual rental space in someareas in London were above these averages. A small number of tenants – introduced tous through the Guardians of the Arches – told us they have noted a more commercial
approach to setting rents in advance of the sale; however, during our audit we found nofurther evidence to suggest that Network Rail’s approach had changed. According to
Network Rail’s framework agreement with the Department, it must follow HM Treasury’sManaging Public Money principles when setting rents with tenants. These stipulate that
rents need to be set on commercial terms.14 Because of rising market rents, tenants
who are less secure financially may be priced out of their rental contracts.
3.15 Network Rail sampled 388 rental spaces, representing about 37% of the total
portfolio’s income. It estimated that this group of tenants were being charged around
31% below market rents as market rents had risen since the last rent review date(see paragraph 3.13). In its communication to potential buyers Network Rail estimatedthat, for the same sample of rental spaces, rents could increase by 54% over the next
three to four years irrespective of a sale. The estimate varies significantly dependingon location; for example, it is around 16% for properties in Wandsworth, yet up to
70% for properties in the City of London and Islington. These increases are based on
expectations of future rental price developments and, assuming Network Rail acts
commercially, would occur even if the portfolio remained in public ownership.
3.16 Around 18% of the current leases are outside of the Landlord and Tenants
Act 1954 (L&T Act). The L&T Act provides tenants with greater security of tenure andimproves the financial incentive for tenants’ investments in the properties. Network Rail
told us that the L&T Act negatively affects Network Rail’s safety objective and, as aresult, Network Rail sought to renegotiate lease contracts outside of the L&T Act when
they came due. The head lease agreed with the new owners requires them to contract
new leases with tenants outside of the L&T Act.

14 Comptroller and Auditor General, The Ministry of Defence’s arrangement with Annington Property Limited,
Session 2017–2019, HC 762, National Audit Office, January 2018. Available at: www.nao.org.uk/report/the-ministry-ofdefences-arrangement-with-annington-property-limited/Network Rail’s sale of railway arches Part Three 35

Figure 13 shows The timing of future rent reviews and lease renewals

Figure 13
The timing of future rent reviews and lease renewals
More than half of the existing leases are due for renewal by 2022, and almost all will undergo
rent review by 2024
Cumulative number of existing leases (%)
100
90
80
70
60
50
40
30
20
10
0

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

Calendar year
Next rent review
Lease end
Notes
1 This figure is based on the existing leases within the portfolio sold as at sale completion.
2

Network Rail’s data are incomplete. The analysis is based on the following populations: next rent review
information is available for 1,955 leases (of a population of 3,745 leases), and lease end dates are available for
1,328 leases (of a population of 1,429 leases).

Source: National Audit Office analysis of the portfolio of rental spaces sold2029

36 Appendix One Network Rail’s sale of railway arches

Appendix One

Our audit approach1
The study examined the value for money of Network Rail’s sale of railway arches.
We reviewed the preparation, process and proceeds of the transaction, to provide an
opinion on:•

how Network Rail prepared for and ran the sale process to secure value for money;•

how Network Rail will ensure the safe operation of the railway in the future; and•the impact of the sale on communities and existing tenants.

2
Figure 14 gives our evaluative criteria. Our evidence base is described inAppendix Two.

Network Rail’s sale of railway arches Appendix One 37

Figure 14 shows our audit approach

Figure 14
Our audit approach
The objective ofgovernment

How this will
be achieved

Our study

Our evaluative
criteria

Our evidence(see Appendix Two
for details)

Our conclusions

In response to a large funding shortfall in its investment programme identified in 2015, Network Rail sought to raisearound £1.8 billion of funds through an asset disposal programme. The main sale in Network Rail’s programme was
the sale of a commercial property portfolio largely made up of railway arches.

Network Rail’s objectives were to maximise deficit-reducing proceeds received before the end of the control period(31 March 2019) while ensuring the safe operation of the railway was not compromised in the sale. Network Railconsidered a number of sale structures and undertook an internal clearance process to establish which rental
spaces it would include in the portfolio for sale. It ran a competitive auction to create tension among bidders.

The study examined whether the sale secured value for money.

Preparation

Process

Proceeds

Were there clear saleobjectives, and did government
prepare well?

Was the sale process
run effectively?

Were the intended outcomes ofthe sale achieved, and what is
the wider impact?

•

We interviewed officials in Network Rail and the Department for Transport and reviewed their advice
to ministers.

••

We reviewed the business cases and the analysis provided by advisers and also interviewed them.
We interviewed representatives from the new owner and wider stakeholders, including existing tenants.

Government’s policy is to sell assets where there is no policy reason for continued public ownership. Network Railsold this property portfolio in pursuit of that policy and did so in a way that achieved the primary sale objective of notprejudicing the safe and sustainable management of the railway infrastructure. Based on this outcome, and the fair
price paid for the portfolio, the sale was value for money. It is, however, of some concern that the impact on tenants
was not an explicit sale objective and was only considered late in the sale process. The long-term value for moneyof this transaction will depend upon several factors, including how Network Rail manages its ongoing relationshipwith the leaseholder and the impact of the sale on stakeholders, including tenants, and local economies.

38 Appendix Two Network Rail’s sale of railway arches

Appendix Two

Our evidence base1
Our conclusion was reached following an analysis of evidence collected between
January and April 2019. Our main methods are outlined below:

Document review
2

We reviewed key documents, including:•the original and final business cases;•

advice from advisers involved in the sale;•data room provided to bidders during the sale;•

submissions to ministers; and•other transaction documents.

Interviews
3

We undertook audit interviews, including:•

officials involved in the preparation and sale process at Network Rail, theDepartment for Transport, HM Treasury and UK Government Investments;•

officials at the Office of Rail and Road;•

government’s advisers involved in the sale;•

representatives of the new owner of the portfolio and management of
The Arch Company; and•wider stakeholders, including existing tenants.

Data analysis
4

We performed data analysis, including:•analysing a database of leases in place at the time of the sale; and•analysing the valuation approaches and the methods underpinning them.

Network Rail’s sale of railway arches Appendix Three 39

Appendix Three

Supporting information
Figure 15 Shows Roles of the main parties involved in the sale of the Arches

Figure 15
Roles of the main parties involved in the sale of the Arches
Party

Roles

Network RailResponsible for ensuring the safe operation of the railway. Owned theportfolio and acted as landlord to tenants. Responsible for preparing andexecuting the sale.

Department forTransport

The shareholder of Network Rail, overseeing its operations. Approved the
project business case in advance of sale launch and before the preferredbidder was selected. Worked with Network Rail and HM Treasury on
determining a sale structure that would satisfy government’s objectives.

HM Treasury

Approved the business case in advance of sale launch and before
the preferred bidder was selected. Worked with Network Rail and theDepartment for Transport on determining a sale structure that would satisfy
government’s objectives.

UK Government
Investments

Acted as advisers to the Department for Transport during the preparationof the sale and the sale process. Regularly attended key commercial
board meetings at Network Rail during the preparation for the sale and thesale process.

Rothschild & Co

Acted as financial adviser to Network Rail throughout the preparation for thesale and the sale process. Its role included leading the execution of the sale,valuation of the portfolio, and advice on the sale structure and sale options.

EY

Acted as financial adviser, providing an independent opinion of themarket value of the portfolio. Also provided vendor due diligence andaccounting advice.

Eversheds

Acted as legal adviser to Network Rail during the preparation for the sale andthe sale process. Developed the portfolio lease, including the railway safety
protections. Worked jointly with Clifford Chance on other legal documents.

Clifford Chance

Acted as legal adviser to Network Rail during the sale process. Developed
the business sale agreement and led interactions with bidders during thesale process. Worked jointly with Eversheds on other legal documents.

JLL

Acted as property adviser to Network Rail during the preparation forthe sale. Reviewed the lease from a buyer’s perspective and advised onsale structure.

Office of Rail and Road

Regulator of Network Rail. Agreed that the proposed sale terms
were consistent with the general consent for land disposals under
Network Rail’s licensing conditions.

Source: National Audit Office analysis of business cases and related documents

40 Appendix Three Network Rail’s sale of railway arches

Figure 16 shows key transaction documents

Figure 16
Key transaction documents
The table below provides a short summary of the key terms in the main transaction documents
Document and purpose

Key terms

Agreement for Lease
Provides for the sale of theportfolio and the payment of thelease premia•

Sets out payment mechanics including the mechanism forcalculating the amounts being transferred and how balance
sheet items will be allocated between parties.

•

Requires a deposit of 5% of total consideration payable on
signing, with the balance due on completion.

•

A small amount of total consideration will be allocated to thenon-property assets, with the balance being payable underthe Agreement for Lease.

•

Contains most of the warranties and indemnities provided by
Network Rail.

••Entered on completion of the sale for a term of 150 years.

•

Similar terms to the portfolio lease, including railway protective
provisions, with certain raft-specific amendments.

•

Allows rafts to be taken back (at market value) if repairs to theraft required to ensure railway safety are deemed uneconomic
by Network Rail.

•

Bespoke terms relevant to the specific assets, including railway
protective provisions to the extent relevant.

Business Sale Agreement
Provides for the transfer of the
non-property assets, comprising
goodwill, equipment, records,
certain contracts and employees

Portfolio Lease (Head Lease)
The main head lease, governing
the vast majority of the portfolio(other than rafts and assets dealt
with under bespoke leases)

Contains railway protective provisions, including rental
compensation and buy-back considerations.

Raft Lease
Head lease governing rafts andrelated land

Bespoke Leases
Small number of bespoke
leases covering certain
non-standard assets

Source: National Audit Office analysis of business case information

Network Rail’s sale of railway arches Appendix Three 41

Figure 17 Shows Interface team’s ongoing role

Figure 17
Interface team’s ongoing role
Summary obligations of Network Rail’s interface team after the saleInspections

Repairs

Rail enhancement
projects•

To assess the condition of viaduct structures, Network Rail will undertake
inspections of arches in normal circumstances at 12-yearly intervals, which
will require access.

•

These inspections require access to the underside of the barrel vault, andgenerally existing occupational leases in use across the estate require tenants
to remove any fixtures and fittings as necessary to allow such inspections
to take place.

•

The duration of an inspection varies depending on the nature of individual
rental spaces but they typically last two to three weeks.

•

Network Rail will be liable for any loss of rental income by the purchaser
during the inspection, as well as any costs incurred in the inspection.

•

If the barrel vault on the underside of the arch is lined, removal will normallybe required to allow the structure to be assessed. The cost of the removal will,in general, be paid by the party that installed the lining.

•

Network Rail will typically provide 20 business days’ notice if repairs are
expected to be conducted, except in emergency situations where no priornotice is needed.

•

Network Rail will compensate the purchaser for any loss of rental income
due to repairs.

•

Network Rail retains the right to take temporary or permanent possession of
any rental space to undertake such improvements.

•

In case of rail enhancement, the purchaser will receive compensation
equating to the loss of rental income for the period of the works.

•

If a rental space is taken back permanently by Network Rail, the purchaser
will receive compensation equating to the diminution in market value of its
assets based on the prevailing market value.

Source: Network Rail’s information memorandum provided to bidders

42 Appendix Three Network Rail’s sale of railway arches

Figure 18 shows Purchaser obligations

Figure 18
Purchaser obligations
Summary of the future owners’ obligations
Repairs•

The purchaser must keep each part of the premises in such a state of
repair and condition so as not to adversely affect the safety function
and/or operation of the railway.

Allow entry•

The purchaser must allow entry to any part of the premises immediatelyon (verbal) notice where determined by Network Rail to be required forthe safety function or operation of the railway.

•

The purchaser must allow entry immediately in emergency scenarios oron 20 business days’ notice in non-emergency scenarios.

•

Where at least 20 business days’ notice is given by Network Rail, thepurchaser must, at its own cost, remove any arch fit-out (excluding any
arch lining), ancillary structures, loose items and/or building, works or
structures on the relevant part of the premises in or on such property
in order to facilitate maintenance and/or repairs.

•

If Network Rail requires removal of any of the items referred to aboveon less than 20 business days’ notice then Network Rail will be
responsible for the costs of removal and reinstatement.

•

No works, alterations or additions will be permitted without consent
unless expressly permitted in the Arch Technical Specification.

•

Consent is not required for arch fit-out or internal works that do not
involve excavation or affixation/attachment to the viaduct.

•

Network Rail’s consent will be required for most alterations.

••

Assignment of the whole of the leases will be permitted.

•

Sub-lettings of parts of the estate on a premium sub-lease will bepermitted so long as at any time no more than 50% of the properties
comprised within a reversionary interest may be subject to anunderlease at a premium.

•

Usual occupational sub-letting will be permitted without consent using
model leases in a form pre-agreed with Network Rail.

Removal of fit-out/chattel

Alterations

Dealings

Sub-lettings

Assignment of parts will be permitted subject to a minimum size of
500 rental spaces being included in each assignment of part.

Source: Network Rail’s information memorandum provided to bidders

Network Rail’s sale of railway arches Appendix Three 43

Figure19 Shows a Summary of Network Rail’s obligations

Figure 19
Network Rail’s obligations
Summary of Network Rail’s obligations
Viaduct retention

Network Rail must keep each viaduct in such a state of repair as necessary toensure the safe operation of the railway.

Entry safeguards

Network Rail must, when exercising any landlord entry rights, repair any physicaldamage caused to the property or fit-out.
Where Network Rail has given 20 business days’ notice to the tenant requiring
removal of any fit-out or tenant’s fittings there is no liability on the part of
Network Rail in respect of any damage to items that should have been removed.
Where Network Rail requires removal of a standard Network Rail arch lining
when exercising its rights, it will meet the costs of removal and reinstatement.

Rentalcompensation

Where any let rental space or part thereof becomes inaccessible and/or
materially incapable of occupation/use as a result of Network Rail exercising
its rights of entry for railway works, then Network Rail will pay compensationequivalent to the rent that would otherwise have been paid by the occupational
tenant of the relevant rental space.

Void periods andvacancy windows

If Network Rail has indicated that it will exercise its entry and occupation rights
during a void period but subsequently (after it enters the premises to exercise its
rights) the space is let then Network Rail will be entitled to a further seven days
without compensation after which compensation will be payable at the rental
rates reserved pursuant to the new lease.

Break rights

Network Rail retains the right to take back part of the premises by way of
break of part of the Long Leases when required for railway purposes.
When break rights are exercised, compensation calculated by reference todiminution of market value is to be independently determined and paid tothe purchaser.
If compensation is payable to occupational tenants or premium sub-tenants
then the purchaser will be responsible for paying this out of compensation
paid by Network Rail.

Source: Network Rail’s information memorandum provided to bidders

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